Stocks closed narrowly lower yesterday. A weak start was reversed by scuttlebutt that the next round of Chinese tariffs would be deferred even without a Phase I agreement this weekend. We are likely to get these rumors, in both directions, up until the deadline. Indeed, even if additional tariffs are deferred, the threat of additional tariffs will not disappear completely. They will remain a market overhang as long as Mr. Trump is President.
Any student of basic economics and monetary theory knows that it takes time, perhaps six to twelve months, for the impact of central bank easing or tightening, to be fully reflected in the economy. The Fed raised rates fairly persistently from late 2017 through the end of 2018. The impact of higher rates and higher tariffs resulted in decelerating economic growth throughout 2019. At the same time, corporate profits actually declined. Only the large amount of corporate stock buybacks kept earnings per share from falling into the red.
This past summer, however, the Fed reversed course and joined other central banks in taking steps to ease monetary conditions. While we haven’t seen the impact yet in terms of GDP growth, the prices of core commodities are clearly on the rise. Lumber prices are up by more than a third since the summer. Copper is rebounding. Improving construction activity, in part tied to lower rates, is an important factor. Oil prices have moved up slowly but steadily from October lows. OPEC restraint and a slowdown in new drilling activity in the U.S. are supportive of higher prices. Another help has been recent weakness in the dollar. The trade weighted dollar index is now virtually the same as it was a year ago. A strong dollar is a headwind to commodity prices and the earnings of multi-national companies. That isn’t yet a tailwind but the absence of any headwinds leads to the same conclusion.
Looking ahead to 2020, stocks are at the top of an upward sloping channel that goes back at least five years. What that says to me is that (1) the long term direction for equities continues to be higher, but (2) over the near term (i.e. the next several months) the market has to pause a bit unless there are substantive reasons for the whole channel to change its slope upwards. Over that period, the rate of gain for stocks has been in the low teens. Over a longer period, which would include the 2007-2009 recession, the rate of gain is closer to 9%. For the market to expand at an even faster rate, either interest rates would have to fall precipitously or earnings growth would have to accelerate significantly beyond current expectations. While the impact of interest rate cuts allows for some chance that earnings could breakout to the upside, that really isn’t likely. Nor is it likely that rates will suddenly fall to new record lows in the face of a solid and even improving economy.
Thus, we believe the channel that has been created over the last half decade will remain the guiding force. That means at times when stocks are near the top of the range or even beyond the top end for brief periods, either stocks have to move sideways for an extended time, or the market will go through a brief and possibly violent mid-course correction. We witnessed two of those in 2018 but none so far in 2019. The trigger could be anything. In 2018, the first correction was ignited by tariffs threats. The second was caused by the Fed tightening money conditions too far.
Note that in both of the above cases, the factors that caused the decline were more mid-course tweaks than material changes in economic direction. The Fed ultimately recognized that it was out of step and reversed course. Markets ultimately recovered all of the lost ground and then some. The early steel and aluminum tariffs were not overly punishing. They ultimately provided little help to the domestic steel and aluminum industries. Subsequent tariffs on Chinese imports may have lowered GDP growth by a half a percentage point at the most. But few companies could blame any earnings weakness directly on the tariffs.
We all know that consumer demand has kept our economy growing. There are few signs yet this Christmas season that the consumer is going on strike. It is hard to find market segments that are overheated. Car sales are in a very modest slump. Manufacturers and dealers have responded with extra incentives and more liberal credit. We will have to watch both to see if they get out of hand. But auto debt isn’t like mortgage debt. Losing your home or losing your car are not the same. Almost always the collateral value of a repossessed car covers the loan. If one had to look at personal debt and find a weak spot, it remains student loans. There are obvious solutions but none are being implemented at the moment. Thus, they remain a concern but are unlikely to stop the economy in its tracks.
The bottom line is that economically, next year looks fine, a repeat of this year or perhaps a bit better. Employment growth will remain solid and the unemployment rate could fall a bit further. The government will continue to spend. Investment spending remains a weak spot. Even with a China mini-deal, investment spending will stay subdued due to a general worldwide overcapacity condition. We aren’t short of manufacturing, office or retail space anywhere.
Against this backdrop, look for interest rates to creep higher. I would put a wide range on the 10-year Treasury of 1.5-2.5% for the year with the likelihood that the higher end of the range will be achieved later in 2020. The dollar has been flat for the past 12 months and should remain close to current levels at least until the election. Together, higher earnings, higher interest rates and a flat dollar lead to an expectation of a slightly higher stock market.
There are always risks that could intercede. Without trying to name them all, I will highlight just a few.
- Tensions in the Middle East could erupt and materially cut off oil supplies for a sustained period. Again, that’s a risk, not a prediction.
- A progressive Democratic candidate could be elected. Someone standing in the shoes of a member of the investor class may deem this extremely unlikely but we are outnumbered. Populists have risen to the top in many places around the world over the past few decades. Clearly a candidate with a decided anti-business, anti-wealth platform would scare markets. So far, markets have been behaving in a manner that suggest almost total disbelief in this possibility. And markets are generally right. But not always.
- China is a risk in its own right. Here I am not talking tariffs but the possibility that Chinese growth could suddenly worsen driven down by a mountain of debt and excessive speculation.
- Too much debt rears its ugly head. Too much debt hasn’t been an issue to date because the cost of debt service has been so low. But if interest rates rise and sustain higher rates, debt service could become a big problem both for corporations and sovereign governments. The canary in the coal mine could be debt supporting highly leveraged oil and oil service companies. If prices fall again and cash flows become inadequate to service debt, the number of failures in the oil patch will skyrocket serving as a template for other overleveraged businesses.
But each of these risks are low probabilities, at least at the moment. More than likely, in a Presidential year, the economy and markets will sustain an upward slope. The greater risk is 2021. Without fears of election retribution, the first year of a Presidential term is when we are most likely to see fiscal policy changes that are damaging, at least over the short term. Whether it is tax increases by a Democrat or renewed tariffs by Trump, 2021 shapes up as a time for more rain clouds than 2020.
Today, Brenda Lee is 75. Rita Moreno is 88.
James M. Meyer, CFA 610-260-2220